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Municipal governments in the U.S. are in a precarious financial situation. Tepid economic growth combined with changes in state aid signal continued revenue weakness.

The cost of meeting pension and healthcare obligations is crowding out key services and necessary investments in infrastructure.

Bankruptcy is increasingly being seen as an option, but states are moving to curtail the ability of municipalities pursue a chapter 9 bankruptcy filing. In the face of these challenges restructurings (both in and out of court) are inevitable; and continued efforts to deny this will only increase the severity and duration of those restructurings when they do come.

Weak Revenues and Where to Cut

The revenue picture for municipalities is bleak and increasingly city managers are being forced to turn to cost cutting and drawing down of surplus cash.

The “City Fiscal Conditions 2011” report, put out by the National League of Cities, offers a detailed review of the situation.

Municipal tax revenue is down or holding at historically low levels across the board.

General city revenues have declined 2.3%, the fifth straight year of declines.

Property tax revenue is forecast to decline 3.7%, with further declines in 2012 and 2013.

Income tax revenue is down 1.6%.

Sales tax revenue is flat, (following a historic decline in this category in 2010).

Given these trends it is clear that municipalities will have considerable difficulty earning their way out of their current fiscal straits.

Contrary to popular opinion local government officials have been aggressively seeking cost savings opportunities.

To their credit these officials have been working to achieve maximum savings in the least harmful (from both a political and a services perspective) ways possible. The City Fiscal Conditions report cited the following areas targeted by city managers:

Personnel-related cuts (72%)

Delaying or cancelling capital infrastructure projects (60%)

Cuts in services other than public safety and human-social services (42%)

Modifying health care benefits for employees (36%)

The difficulty with cuts in municipal budgets, as I have been arguing all year, is that there are very few pain-free areas to cut. Personnel cuts are ugly, and along with modifications to health care benefits these cuts pose the risk of emotionally charged and distracting media coverage. Deferring capital infrastructure projects is a temporary remedy at best and potentially sets the stage for more serious budgetary pressures in years to come, as regular maintenance needs, if deferred long enough, become emergency needs.

Cuts in non-essential services seem pain-free until we realize that libraries and community centers would be on the chopping block, and the quality of life issues associated with communities no longer able to afford these services cannot be ignored. In reducing local government expenditures there is no free lunch; local government officials have been given the joyless task of desperately seeking the least bad option.

Stretched States

A major source of revenue for municipalities is state aid, but states are facing pressures of their own. The most strained states have achieved worrying levels of indebtedness. Pension and healthcare costs are strangling state budgets and those elected officials that are openly acknowledging the scope of the problem are facing challenges. Given these conditions it is no surprise that aid to municipalities is being cut.

In a recent report Moody’s presents a worrisome picture of state indebtedness. The credit rating agency finds, in its “2011 State Debt Medians Report” that by several measures some states are starting to look fairly stretched. Five states show up as the most stressed by three different measures:

Net Tax-Supported Debt (Per Capita)

State Avg: $1,408

State Median: $1,066

Connecticut ($5,236)

Massachusetts ($4,711)

Hawaii ($4,236)

New Jersey ($3,940)

New York ($3,149)

Net Tax-Supported Debt (As % of State GDP)

State Avg: 4.48%

State Median: 3.94%

Massachusetts (8.62%)

Hawaii (8.38%)

Connecticut (8.38%)

New Jersey (7.19%)

New York (5.68%)

Net Tax-Supported Debt (As % of Personal Income)

State Median: 2.8%

Hawaii (10.1%)

Massachusetts (9.5%)

Connecticut (9.5%)

New Jersey (7.9%)

New York (6.8%)

These states and others are quickly reaching a point at which their own financial health is being called into question, irrespective of the health of the struggling cities within their borders.

States such as Rhode Island and New Jersey that are seeking to address their structural issues are facing considerable headwinds. In Rhode Island, general treasurer Gina Raimondo has been touring the state explaining to residents the severe challenges facing a state in which 10 percent of revenues are currently going to pension and healthcare benefits for retirees, with the number set to move toward 20 percent in the near future. New Jersey governor Chris Christie faces a similarly thankless task, and his efforts to address structural deficits must seem somewhat more Sisyphean after the news that the state’s bonded debt increased to $38.1 billion, with healthcare obligations having increased by 35 percent in the past year, to $13.5 billion. Generally speaking, when elected officials are going on tours explaining to retirees that their benefits must be cut to maintain services, and fiscal hawks are seeking to spin a slowing rate of debt increases as a win, the fiscal picture is fairly bleak.

State aid is being cut as states seek to address their own budgetary problems. The City Fiscal Conditions 2011 report noted:

Since 2009, cities report cuts in general aid (50%), shared revenues (49%), and reductions in reimbursements and other transfers (32%). As states make these cuts to balance their budgets, it puts greater budgetary pressure on local governments that must balance their budgets as well.

When the bankruptcy code was amended in 1978, the idea of a state filing bankruptcy was not on the radar of most officials, and so states, unlike municipalities, do not have recourse to chapter 9. Debt levels are rising, and for the most indebted are already worryingly high. Pension and healthcare costs are crowding out other spending, with no relief in sight. The financial stress that states are under is undoubtedly worsening the situation of municipalities, as states reduce aid and seek to address their own needs before looking to the needs of the troubled cities within their borders.

Shifting Market Sentiment

A permissive financing market has allowed governments to increase their indebtedness, with little thought to the implications of rising debt service on their long-term financial health.

The current travails of municipal and state governments might not be quite so severe if it were not for a permissive financing market. A flight to (perceived) quality among investors, the tax advantages of owning municipal and state bonds and a historically low default rate have kept demand high even as underlying fundamentals have weakened. While most investors remain sanguine, recent developments in the municipal finance arena are signaling an end to the status quo.

The status of revenue bonds has been called into question. According to a recent WSJarticle:

Jefferson County's lawyers have asked in court filings that holders of the sewer debt not be given preferential treatment. They contend that once the county filed for bankruptcy protection, sewer bondholders lost the right to be paid until the case is resolved.

For much of the last year those objecting to my firm’s position on impending widespread municipal distress have pointed to revenue bonds as being particularly safe and doubly secure from any distress associated with a given municipality. This argument has always struck me as overly simplistic, and in the wake of this latest development the market seems to agree; Jefferson County’s affected bonds are currently trading 23% below par. With revenue bonds accounting for two-thirds of traded municipal bonds, resolution of this question is no small matter.

Bond insurer Assured Guarantee, facing losses from Harrisburg, Jefferson County and other municipal distress hotspots has indicated that it will be pulling back in light of recent developments. CEO Dominic Frederico, citing the concessions sought by Harrisburg and the failure to achieve an out-of-court solution in Jefferson County offered the following: “Local governments must recognize their responsibilities to live up to the promises made by current and former duly elected officials.” I sympathize with Dominic Frederico, offering municipal bond insurance seems to have been a very good business until suddenly it was not. With local governments increasingly looking at every option, it must seem that much of the insurance Assured Guarantee has provided may have been disastrously mispriced.

Getting To Reality

I have noted before that my favorite aspect of distressed situations is that in the end, reality must be acknowledged. Creditors to local governments can tell themselves whatever story they want about the primacy of their claims, the ability of local governments to tax their way to prosperity, the ability of states to bail out governments, etc. In the end those are just comforting stories. The reality is that municipal governments across the country are stretched. Revenues are down and painful cost cutting is the order of the day. States that may lack the financial wherewithal to bailout their cities are nonetheless interfering with legislation that does nothing to change facts on the ground. Pension and healthcare costs are increasing and absent bankruptcy there is no good tool for addressing those costs. Widespread municipal distress will happen because we are simply out of options; delay will only worsen the inevitable pain.